Definition, Explanation and Use:
The trade payables’ payment period ratio represents the time lag between a credit purchase and making payment to the supplier. As trade payables relate to credit purchases so credit purchases figure should be used in calculating this ratio. However as the amount of credit purchase is usually not separately available in the income statement so in that case total purchases could be used.
Like other ratios, this ratio is observed over a period of time and compared with the other businesses in the same industry. In addition, the trade payables payment period is compared with the trade receivable collection period to compare the pace of receiving and paying cash on trading activities.
Analysis and Interpretation:
Usually a lengthy payment period is preferred however it may result in loss of credit worthiness which may, in turn, lead to:
- Withdrawal of credit in future,
- Delays in processing orders,
- Lower priority in the future and
- Interest charged on overdue amounts
Where a supplier offers a cash discount for prompt payment, the benefits of delaying payment must be weighted against the discounts foregone.
A high average credit period taken may suggest the business has very good relations with its suppliers but it usually indicate otherwise, i.e., trade payables are not being paid because there is no cash available. It may therefore be a symptom of financial distress.